In his recent post, “The True Story of the Oil Crisis of 1973-1974,” October 19, 2023, John Phelan gets the facts right but the economic interpretation wrong.
John argues, as the late Wall Street Journal editor Robert Bartley had argued, that OPEC quadrupled the price of oil in order to keep the price constant in terms of gold. John writes:
“In the first half of 1974,” Bartley wrote, “after “the shock,” a barrel of oil was worth almost 1/12 of an ounce of gold,” just as it was in 1969.
But he also quotes the September 1973 OPEC resolution’s statement that OPEC’s members would adopt “ways and means to offset any adverse effects on the per barrel real income of Member Countries resulting from the international monetary developments as of 15th August 1971.”
Why do I say “But?” Because real income is measured in terms of what it will buy. OPEC members didn’t sell their oil so they could buy only gold. They sold their oil so that they could buy goods and services. By how much did the overall prices for goods and services rise? Between 1969 and 1974, by which time almost all the price controls and been ended, the CPI rose by 35%. So OPEC’s attempt to keep their per barrel income constant in real terms would explain at most a 35% increase in the price of oil between 1969 and 1974, not a 300% increase.
Why would OPEC refer to “the international monetary developments as of 15th August 1971?” The most likely reason is that doing so was good PR for a move that OPEC knew would be unpopular, namely a quadrupling of the price of oil over a few months.
There could be another reason that somewhat fits OPEC’s idea of bringing gold into the discussion. When any cartel sets prices, it needs to set them with reference to something. But what? Possibly the OPEC members thought they could hold the cartel’s price together for a few years by setting it in terms of gold. But that’s different from OPEC’s claim that it was simply trying to maintain the Member Countries’ per barrel real income.
What about the effect of the oil price increase on inflation? It was not large. In 1973, we imported approximately 6.3 million barrels per day (mbd) of oil. So when the price of oil quadrupled, from $2.75 per barrel in early 1973 to $11 per barrel in early 1974, the annual income transfer to foreign producers due to that price increase was $8.25 per barrel times 6.3 mbd times 365 days, which is $19 billion. U.S. GDP in 1973 was $1.326 trillion. $19 billion is 1.4% of $1.326 trillion. Using the equation of exchange, MV = Py, where M is the money supply, V is the velocity of money, P is the price level, and y is real GDP, we can calculate the part of inflation due to the oil price increase. The effect of y falling by 1.4% is a 1.4% one-time increase in the price level. So the increased price of oil was a substantial contributor, but not the most important contributor, to the inflation from early 1973 to early 1974, and only a small contributor to the inflation from 1969 to 1974.
You might wonder why I consider only the price increase on imports. Didn’t the price of domestic oil increase also? Yes. But two things. First, Nixon’s price controls didn’t allow the domestic price of oil to rise to equal the world price. That didn’t happen until January 1981, when Ronald Reagan, in his first month in office used the discretion the president had been given in 1980 legislation to end the price controls on oil and gasoline. But second, and more important, even if the price of domestic oil had been allowed to rise to the world price, that would have represented a transfer of income from domestic consumers to domestic producers but not a loss of real income to the U.S. as a whole.
READER COMMENTS
Thomas L Hutcheson
Oct 21 2023 at 9:32am
I see no overlap between what OPEC said about their exercise of monopoly power and the truly absurd response of the US and most other net importing countries to the change in international prices.
The costs from our self-inflicted wounds must have been far greater than the real income effect of the change in terms of trade. Sort of practice for the much bigger mistaken response to 9/11.
steve
Oct 21 2023 at 9:28pm
Seems like there ought to be a multiplier effect. No?
Steve
Matthias
Oct 21 2023 at 11:56pm
Why would you expect the multiplier to be larger than 1?
There would also be substitution effects and people economising by using less oil. Those are factors that would reduce the multiplier, all else being equal.
Matthias
Oct 21 2023 at 11:57pm
I’m not sure why that is more important? As a consumer I don’t care whether I pay more to local or foreign fat cats, do you?
Jon Murphy
Oct 22 2023 at 7:11am
Because the question is about a reduction of real income to the US as a whole. Since domestic producers are part of the US, a transfer of wealth represents no change in real income in the aggregate.
David Henderson
Oct 22 2023 at 11:39am
No, I don’t care as a consumer, but, as I pointed out in the last sentence of my post, the way to figure out the part of inflation due to the loss of real income to Americans is to compute the loss of real income to Americans, not just the loss of real income to American consumers.
Jon Murphy has answered correctly.
Thomas L Hutcheson
Oct 23 2023 at 8:53am
And a progressive tax system captures some of the rent flowing to owners of domestic producing firms to reduce deficits and spur future growth.
Mike Burnson
Oct 23 2023 at 5:46pm
What is missing from the conversation thus far is the benefit of increasing domestic production. Freeing US oil prices to compete with global pricing meant that more oil would be produced, thus reducing the impact of OPEC cartel pricing. Higher American production means lower prices globally. Further, that puts more Americans to work, paying more income taxes, buying more goods and services. The US was damaged, both “seen and unseen”, by price controls.
OPEC was a relatively weak entity at that time. It became more powerful precisely because we restricted our own production, thereby empowering their control over the petroleum market.
David Henderson
Oct 24 2023 at 10:09am
Good point, Mike. Indeed, one of the first pieces I submitted to the Wall Street Journal (sometime in 1974, I think) made that point. As I recall, Bruce Bartlett also wrote a piece or two making that point. They published his, not mine.
I’m not sure it’s “missing” from the discussion, though, because the discussion didn’t hinge on that.
Roger McKinney
Oct 24 2023 at 10:39am
Gold was still illegal for Americans to own in 1974, so we didn’t think of it as money and hadn’t for a generation. But I can see most people outside the West continuing to see it as the only real money. In India, many people still do. That the OPEC wanted to maintain parity with real money makes the most sense to me.
Why would they trust government manipulated inflation figures anyway?
David Henderson
Oct 24 2023 at 3:18pm
You write:
Actually, it became legal on December 31, 1974. That’s a nitpick on my part, though, since your reasoning applies to early 1974.
You write:
If you look at what people use to exchange, the dollar comes up as a pretty plausible contender.
You write:
The main manipulation at the time was the price controls, but most of those had ended by early 1974. I’m betting that I have way more confidence in the integrity of the Bureau of Labor Statistics than you do. But even if I didn’t, could manipulation account for the huge disconnect between the CPI and the price of gold? One or two percentage points per year, maybe. But 200% or 300% in a year?
Robert Bradley
Oct 24 2023 at 8:18pm
“Nixon’s price controls didn’t allow the domestic price of [crude] oil to rise to equal the world price. That didn’t happen until January 1981…”
Americans were in the gasoline lines for only months of a multi-year ordeal. I wonder if this meant the ‘world price’ was operative in the US. I know that the oil reseller boom and the fact that refiners could mix unregulated import prices into their price-controlled domestic mix had an effect.
David Henderson
Oct 24 2023 at 11:26pm
You write:
No, the world price wasn’t operative and your last sentence hints at why. President Ford, noticing that some refiners had “unfair” access to below-market crude, introduced the entitlement system. That acted as a subsidy for importing oil and led to an artificially subsidized often market-clearing price for refined product. A bunch of us were trying to model that in 1974 and 1975. I came close but Joe Kalt, a fellow UCLA Ph.D. student, nailed it. That was his dissertation (under Demsetz, I think) and he made it into a book. It landed him a job at Harvard. His book lays it out nicely.
Jim Glass
Oct 24 2023 at 11:40pm
The price of oil went from $3.50 to $39.50 during the oil shock years, up > 1,000%, as I detailed in my comment under his post. The more-than-quadrupling was in the real price, over inflation. (Or the real price quintupled, depending on the oil one is pricing.)
From June of your start year, 1969, to June 1980, the date of the oil price peak, BLS says the CPI price level increased from 100 to 226. (Rather less than the 11x increase in the price of oil.)
That’s in the USA of course. In other countries inflation rates differed sharply depending on their central bank policies, as also detailed in my other comment.
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